What did you truly expect?

EM sentiment has turned.

The negativity towards emerging market assets is switching and the rebound we have seen in the likes of Chinese equities and the South African rand is a testament to this. I have promoted an EM outperformance trade for months and I have been wrong, up until now. Despite cutting some China exposure several weeks ago, I remain overweight China and even with the Chinese backing out of trade talks, probably until after the mid-term elections and President Xi’s visit in November, we are likely to see a continuation of a rebound in Chinese stocks over the next several weeks.

With US equities being buoyed by a rush into cyclical stocks, behavior that is reminiscent of a belief that we are early cycle, not late, there appears to be little on the horizon to prevent a narrative that EM has structurally bottomed. While the valuation argument is a thesis that I have been making for months, I remain very concerned about the enthusiasm for US assets that are separating from the longer term fundamentals, especially given the headwinds we will likely see in the next three to six months:

US mid-term elections are increasingly looking like an overwhelming rebuttal of President Trump, taking with it, his business-friendly agenda of deregulation and the prospect of making many of his tax cuts permanent. There is a growing likelihood that the United States Senate will fall back into Democrat hands. I do not want to hear the arguments that gridlock is good for markets. US politics is swinging left and that is detrimental for US equity multiples.

Heading into 2019, as the impacts of the tax cut induced sugar high start to wane, growth and profits for the upcoming year will become increasingly difficult to exceed the lofty levels set in 2018. Assuming the USD stays around current levels, year on year profit comparisons in H1 2019 will be harmed by a slightly higher USD and the 2018 tax benefit will also create a difficult hurdle for corporate America. Base effects could easily lead to low single digit earnings growth for 2019.

The mindset regarding tariffs is understandable but also, premature. President Trump has indicated that we are likely to get tariffs on pretty much every Chinese import into the United States and when this narrative was made clear, speculators took the opportunity to say that this is the low point for trade. They started buying Chinese stocks, industrial equities and copper aggressively in a classic “sell the rumor / buy the fact” mentality. This is premature. As my discussions with Chad Bown from the Peterson Institute have revealed, tariffs on global autos coming into the United States are increasingly likely and we are yet to conclude a deal between the US and Canada. President Trump isn’t done yet and market should show a degree of caution.

I have been truly surprised by the seamless rotation out of technology stocks and into cyclicals and financials with this having no beta impact on broader indices. Given the exposure that the average investor still has to US, mega-cap technology stocks, the fact that the pairing of these positions has not led to index weakness has been extraordinary. Higher bond yields have clearly helped financials but are we really heading to a new paradigm for long term US interest rates? What has changed economically in the past month? I say, nothing and in fact, the tariff outlook is only getting worse. I see little on the horizon to see US 10-year yields to break out of the 30bps trading range where they have meandered for the vast majority of the year. The short-term euphoria regarding financials will fade quickly if US 10-year yields fall back through 3% over the next couple of weeks.

The Q4 trade off: Positive seasonality versus negative thematics.

Year after year, the hedge fund community tends to make the majority of its returns in the final quarter of the year. In fact, for the last four years, US stocks and US 10-year yields have ended December at there year to date highs. It is hard to argue against this and if algorithms could salivate at an opportunity, they probably would. That said, I do find it very difficult to see how the extraordinary Sharpe ratio returns being generated by US indices (ex NASDAQ) at this time can continue with the array of structural concerns that are on the agenda for the next six months.

For example, if the GBP is going to plummet in the next several quarters due to the realization that a Hard Brexit is coming, how does the USD not strengthen appreciably and threaten the performance of emerging market stocks? My valuation arguments are all well and good, but part of my rationale has been that USD funding wasn’t actually that restrictive. So far this year, with the USD index roughly stuck between 90-95, this has been correct but will the complete unravelling of Brexit negotiations both with the EU and the UK Conservative Party, lead to a sharply higher USD? It is hard to argue against this.

On a two to three-year view, long EM versus short US equities is something I am very supportive of but there are going to be enormous headwinds for the globe in the next six months. While I think US outperformance has come to an end, a 10% correction in US equities will lead to negative index returns in Europe, Japan and most of EM. China does have the ability to beat to its own drum but to expect a positive return environment if the rest of the globe is weak is too optimistic. SPX hedges are required.

For me, there is a sense of inevitability regarding the outlook for US profits in 2019 due to base effects. Inevitability over trade and the same over Brexit. The US is swinging left politically and there is an inevitability regarding a peaking in the pro-business environment that has dominated returns for US based investors since November 9th, 2016. How long it takes for markets to respond remains to be seen? Will US equity investors continue to focus on buybacks above all else? Will seasonality overwhelm everything I have outlined above? Maybe for a while but the investing environment is shifting, and I believe will eventually manifest itself in lower US equity prices and the multiple investors are prepared to pay.